Modelling excess profit

Abstract

This paper deals with the problem of modelling in a formal way the concept of excess profit. A common idea is that excess profit is an unequivocal concept, being the difference between profit and costs, where all types of costs are taken into account, included the opportunity cost, i.e. the profit the entrepreneur would obtain if she invested in another business. This paper aims at showing that this difference is not univocal and that different approaches may be followed to give voice to such a notion. It turns out that two different interpretations are possible. The one existing in the literature is well described by Preinrich (1938. Annual survey of economic theory: the theory of depreciation. Econometrica 6 (1), 219–241); Edwards and Bell (1961. The Theory and Measurement of Business Income Berkeley, University of California Press) and, more recently, in the financial literature, by Stewart (1991. The Quest for Value: the EVA™ Management Guide, HarperCollins, Publishers Inc.). The interpretation here provided gives rise to a different way of modelling the notion of excess profit. While the existing models are tied to the financial literature, the model here presented is more akin to a microeconomic perspective. The paper focuses on the formal relations among the various models and necessary and sufficient conditions are provided for the integration of all models in the systemic framework here adopted.